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UPDATE 2 -Fed's Yellen: US economy still needs ultra-low rates

(Adds Yellen comments)

SAN DIEGO, Feb 22 (Reuters) - The U.S. economy still needs extraordinarily low interest rates, as inflation is “undesirably low” and growth will likely be sluggish for several years, a top Federal Reserve official said Monday.

San Francisco Federal Reserve Bank President Janet Yellen told the University of San Diego’s business school that the U.S. economy will likely grow at a pace of about 3.5 percent this year and 4.5 percent next year.

“Even though the recession appears to be over, it does not mean that we are where we want to be. Even with my moderate growth forecast, the economy will be operating well below its potential for several years,” Yellen said.

The Fed has kept its target interest rate for bank-to-bank overnight lending near zero since December 2008 to combat the worst financial crisis and economic downturn since the Great Depression. It has also injected more than $1 trillion into the economy.

“If it were positive to take interest rates into negative territory I would be voting for that,” she told reporters after the speech.

Yellen is not a voting member of the Fed’s monetary policy-setting Federal Open Market Committee this year.

Unemployment, currently at an “unacceptably high” rate of 9.7 percent, will likely only decline to 9.25 percent this year and 8 percent by the end of next year, she said. It will be many years before the rate returns to the 5 percent she views as signaling full employment.

“Accommodative policy is appropriate, in my view, because the economy is operating well below its potential and inflation is undesirably low,” Yellen said in the speech. “I believe this is not the time to be removing monetary stimulus.”

Speculation on the likely timing of monetary tightening heated up last week after the Fed raised the interest rate it charges for emergency bank loans to 0.75 percent from 0.50 percent. But Fed officials have stressed the move, the first increase in any of the Fed’s lending rates since the financial crisis began in 2007, did not amount to monetary tightening.

Yellen also said the increase in the discount rate reflected a return to more normal financial conditions.

The increase in the discount rate, she said, was intended to discourage banks from borrowing from the Fed when they have other options. The rate currently is set 50 basis points higher than the high end of the Fed’s target for overnight lending, a gap that may be adequate to reach that goal, she said.

“There’s no presumption this is the first of many steps,” she said.

When the time does come for monetary tightening, raising the interest rate the Fed pays on reserves will take a “lead role,” she said.

Fed officials are in broad agreement over the steps the central bank needs to take to withdraw the support it currently extends to the financial system, she said.

Next month the Fed plans to end one of the tools it has used to help revive the economy -- its $1.25 trillion program to purchase mortgage-related debt.

With the housing market stabilized but falling far short of revitalization, ending the program could make the housing market weaken again, she said. Still, she said, there would be a high bar to any decision to resume buying mortgage-backed debt.

“It would have to be a serious change in the outlook” to merit such a reversal, she said.

But only after economic conditions improve and monetary tightening underway will the Fed possibly sell some of the assets that currently bloat its balance sheet, she said.

Yellen’s speech suggested she thought such moves may be far in the future. While other Fed officials like Kansas City Fed President Thomas Hoenig have warned the ballooning federal deficit could lead to runaway inflation, Yellen played down such fears.

“There’s no evidence that big government deficits cause high inflation in advanced economies with independent central banks, such as the Fed,” she said.

In fact, she said, inflation is “already very low and trending downward.”

In comments to reporters after the speech, she said deflation -- a sustained decline in prices -- is unlikely. And while the Fed is on the lookout for potential future bubbles, and in search of new tools to keep such bubbles in check, so far she sees none on the horizon.

Additional reporting by Kristina Cooke in New York, Editing by Chizu Nomiyama